The Melting Liquidation Preference

I’ve been through two severe market declines, both in 2001 and 2009. Public market volatility at the beginning of 2016 gave birth to a lot of “doom and gloom” posts on VC blogs. The public markets have recovered, but the scare earlier this year seems to have resulted in more conservative cash planning within early stage companies. Investors and founders alike are paying closer attention to multiples. It also got VCs like me thinking more about structure.

There is a large wave of companies that raised capital in the last 18–24 months that will come to market for capital soon or have recently done so. The key obstacle for these companies is that they likely raised capital at a valuation higher than they could retrieve in the markets today. These companies might have made substantial progress in their businesses, thereby reducing the risk, and therefore increasing the valuation….or so the argument goes. The issue, however, is that the price for unit of risk has gone down. In other words, there is a generation of companies that need to accomplish significant traction just to earn their most recent valuation. I’ve heard several people recently proclaim “flat is the new up round.”

Here’s the thing: one can’t go to the NYSE and say IBM should be worth more than what they paid for it because IBM grew a lot since they bought it. The market doesn’t work that way. The market prices as of *now* and not relative to “ancient” history. The willingness of the market to pay for a unit of growth, earnings, revenue, etc. fluctuates based on future expectations.

As more companies inevitably struggle to climb back to their prior valuations, companies can face a downround. Existing investors and founders don’t like downrounds. They are painful financially, psychologically, and administratively. In a lot of these cases, downrounds are appropriate because of where the market trades. In other words, they are “fair”. To avoid the discomfort of such a round, companies can maintain their valuation but change the liquidation preference/structure, opting for participating preferred (uncapped), participating preferred with a cap (such as 3–4x) or multiple liquidation preferences (with “either/or” straight prefered), versus enduring a downround. None of these structures are “market” nowadays, but that might change. These structures can help the market to operate as parties trade downside and upside potential to arrive at a deal.

Investors should consider is that getting liquidation preference in exchange for valuation isn’t a 1 for 1 trade. Consider that often liquidation preferences are haircut in later rounds as new investors reduce the layers of sediment above a management team payout. When these discussions occur, the management team has an incentive to align with a new investor suggesting this change, because the team stands to benefit from this reduction in liquidation preference. It makes common more valuable. A downround, however, is a different circumstance. All existing shareholders (investors, founders and employees alike) are aligned to resist the lower valuation since each is uniformly affected.

So when making this trade, one should assign some probability the liquidation preference will matter. You have to examine downside scenarios, whether a cap will be exceeded and the long term capital requirements that might foretell a future haircut. From time to time, management teams get a carve out senior to the liquidation preference — yet another way the liquidation preference is worth less. There are also upside scenarios where liquidation preferences aren’t paid, primarily (a) in straight preferred when the exit proceeds are greater as-if converted to common and (b) in an IPO of sufficient size.

With the company’s longer term welfare in mind, artificially propping up the valuation of the business has consequences. The company still has to catch up to a now perpetuated artificially high valuation, which can make it hard to raise the next round. That valuation can also mean that employees are further out of the money in their options, depending on how the increased liquidation preference is incorporated into the calculation of the strike price. With the number of flat rounds or continuation rounds being done recently, this is a real risk. Sometimes a way to keep the valuation flat and avoid a downround is to sweeten the liquidation preference structure for investors. So we may see participating preferred more frequently than we have in recent years.

You might also find investors who are more concerned than in the past to have structural downside protection. In recent years, this has been less of a concern as the goal was to capture upside potential, and with exit markets frothy, trading upside for downside seemed silly. But it’s an important tool to help markets clear, so long as investors consider the expected value rather than the notional value of the liquidation preference.

Jason is a venture capitalist, business school professor and former software engineer. Jason is a Partner at Origin Ventures and he has been in the venture business since 2001. He also teaches the venture capital and private equity lab class at Chicago Booth.

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